by Peter Lynch
Contrast the sorry stock performance of Xerox to that of Philip Morris, a company that sells cigarettes—a negative-growth industry in the U.S. Over the past fifteen years Xerox dropped from $160 to $60, while Philip Morris rose from $14 to $90. Year after year Philip Morris increases its earnings by expanding its market share abroad, by raising prices, and by cutting costs. Because of its brand names—Marlboro, Virginia Slims, Benson & Hedges, Merit, etc.—Philip Morris has found its niche. Negative-growth industries do not attract flocks of competitors.
BEWARE THE NEXT SOMETHING
Another stock I’d avoid is a stock in a company that’s been touted as the next IBM, the next McDonald’s, the next Intel, or the next Disney, etc. In my experience the next of something almost never is—on Broadway, the best-seller list, the National Basketball Association, or Wall Street. How many times have you heard that some player is supposed to be the next Willie Mays, or that some novel is supposed to be the next Moby Dick, only to find that the first is cut from the team, and the second is quietly remaindered? In stocks there’s a similar curse.
In fact, when people tout a stock as the next of something, it often marks the end of prosperity not only for the imitator but also for the original to which it is being compared. When other computer companies were called the “next IBM,” you could have guessed that IBM would go through some terrible times, and it has. Today most computer companies are trying not to become the next IBM, which may mean better times ahead for that beleaguered firm.
After Circuit City Stores (formerly Wards) became a successful electronics retailer, there was a string of nexts, including First Family, Good Guys, Highland Superstores, Crazy Eddie, and Fretters. Circuit City is up fourfold since 1984, when it was listed on the New York Stock Exchange, somehow avoiding the IBM curse, while all of the nexts have lost between 59 and 96 percent of their original value.
The next Toys “R” Us was Child World, which also stumbled; and the next Price Club was the Warehouse Club, which fared no better.
AVOID DIWORSEIFICATIONS
Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated diworseifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. This ensures that losses will be maximized.
Every second decade the corporations seem to alternate between rampant diworseification (when billions are spent on exciting acquisitions) and rampant restructuring (when those no-longer-exciting acquisitions are sold off for less than the original purchase price). The same thing happens to people and their sailboats.
These frequent episodes of acquiring and then regretting, only to divest and acquire and regret once again, could be applauded as a form of transfer payment from the shareholders of the large and cash-rich corporation to the shareholders of the smaller entity being taken over, since the large corporations so often overpay. The why of all this I’ve never understood, except perhaps that corporate management finds it more exciting to take over smaller companies, however expensive, than to buy back shares or mail dividend checks, which requires no imagination.
Perhaps psychologists should analyze this. Some corporations, like some individuals, just can’t stand prosperity.
From an investor’s point of view, the only two good things about diworseification are owning shares in the company that’s being acquired, or in finding turnaround opportunities among the victims of diworse-ification that have decided to restructure.
There are so many examples of diworseification I hardly know where to begin. Mobil Oil once diworseified by buying Marcor Inc. One of Marcor’s businesses was a retailer in an unfamiliar business that plagued Mobil for years. Marcor’s other main business was Container Corporation, which Mobil later sold at a very low price. Mobil blew more millions by paying too much for Superior Oil.
Since the 1980 peak in oil prices, Mobil stock has risen only 10 percent, while Exxon has doubled. Beyond a couple of unfortunate and relatively small acquisitions such as Reliance Electric, plus an ill-fated venture-capital subsidiary, Exxon resisted diworseification and stuck to its own business. Its excess cash went to buying back its own stock. The shareholders of Exxon have done much better than the shareholders of Mobil, although new management is turning Mobil around. It sold Montgomery Ward in 1988.
The follies of Gillette I’ve already described. That company not only bought the medicine chest, it diworseified into digital watches and then announced a write-off of the whole fiasco. It’s the only time in my memory that a major company explained how it got out of a losing business before anybody realized it had gotten into the business in the first place. Gillette, too, has made major reforms and has lately mended its ways.
General Mills owned Chinese restaurants, Italian restaurants, steak houses, Parker Brothers toys, Izod shirts, coins, stamps, travel companies, Eddie Bauer retail outlets, and Footjoy products, many acquired in the 1960s.
The 1960s was the greatest decade for diworseification since the Roman Empire diworseified all over Europe and northern Africa. It’s hard to find a respectable company that didn’t diworseify in the 1960s, when the best and the brightest believed they could manage one business as well as the next.
Allied Chemical bought everything but the kitchen sink, and probably somewhere in there it actually took over a company that made kitchen sinks. Times Mirror diworseified, and so did Merck, but both have wised up and returned to their publishing and their drugs.
U.S. Industries made 300 acquisitions in a single year. They should have called themselves one-a-day. Beatrice Foods expanded from edibles into inedibles, and after that anything was possible.
This great acquisitive era ended in the market collapse of 1973–74, when Wall Street finally realized that the best and the brightest were not as ingenious as expected, and even the most charming of corporate directors could not turn all those toads they bought into princes.
That’s not to say it’s always foolish to make acquisitions. It’s a very good strategy in situations where the basic business is terrible. We would never have heard of Warren Buffett or his Berkshire Hathaway if Buffett had stuck to textiles. The same might be said of the Tisches, who started out with a chain of movie theaters (Loew’s) and used the proceeds to buy a tobacco company (Lorillard), which in turn helped them acquire an insurance company (CNA), which led to their taking a huge position in CBS. The trick is that you have to know how to make the right acquisitions and then manage them successfully.
Consider the story of Melville and Genesco, two shoe manufacturers—one that successfully diversified and one that diworseified (see charts). Thirty years ago Melville was manufacturing men’s shoes almost exclusively for its own family of shoe stores, Thom McAn. Sales grew as the company began to lease shoe departments in other stores, most notably the chain of K mart stores. When K mart began its great expansion in 1962, Melville’s profits exploded. After years of experience in discount shoe retailing, the company launched into a series of acquisitions, always establishing the success of one before proceeding with another: they purchased CVS, a discount drugstore operation, in 1969; Marshall’s, a discount apparel chain, in 1976; and Kay-Bee Toys in 1981. During the same period, Melville reduced the number of its shoe manufacturing plants from twenty-two in 1965 to just one in 1982. Slowly, but efficiently, a shoe manufacturer had transformed itself into a diversified retailer.
Unlike Melville, Genesco went off in a frenzy. Starting in 1956, it acquired Bonwit Teller, Henri Bendel, Tiffany, and Kress (variety stores), then got into security consulting, men’s and women’s jewelry, knitting materials, textiles, blue jeans, and numerous other forms of retailing and wholesaling—while still trying to manufacture shoes. In the seventeen-year period between 1956 and 1973, Genesco made 150 acquisitions. These purchases greatly increased the company’s sales, so Genesco got bigger on paper, but its fundamentals were deteriorating.
The difference in Melville
’s and Genesco’s strategies ultimately showed up in the earnings and stock performances of the two companies. Both stocks suffered during the 1973–74 bear market. But Melville’s earnings were growing steadily and its stock rebounded; it had become a thirtybagger by 1987. As for Genesco, its financial position continued to deteriorate after 1974, and the stock has never come back.
Why did Melville succeed while Genesco failed? The answer has a lot to do with a concept called synergy. “Synergy” is a fancy name for the two-plus-two-equals-five theory of putting together related businesses and making the whole thing work.
The synergy theory suggests, for example, that since Marriott already operates hotels and restaurants, it made sense for them to acquire the Big Boy restaurant chain, and also to acquire the subsidiary that provides meal service to prisons and colleges. (College students will tell you there’s a lot of synergy between prison food and college food.) But what would Marriott know about auto parts or video games?
In practice, sometimes acquisitions produce synergy, and sometimes they don’t. Gillette, the leading manufacturer of razor blades, got some synergy when it acquired the Foamy shaving cream line. However, that didn’t extend to shampoo, lotion, and all the other toiletry items that Gillette brought under its control. Buffett’s Berkshire Hathaway has bought everything from candy stores to furniture stores to newspapers, with spectacular results. Then again, Buffett’s company is devoted to acquisitions.
If a company must acquire something, I’d prefer it to be a related business, but acquisitions in general make me nervous. There’s a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them. I’d rather see a vigorous buyback of shares, which is the purest synergy of all.
BEWARE THE WHISPER STOCK
I get calls all the time from people who recommend solid companies for Magellan, and then, usually after they’ve lowered their voices as if to confide something personal, they add: “There’s this great stock I want to tell you about. It’s too small for your fund, but you ought to look at it for your own account. It’s a fascinating idea, and it could be a big winner.”
These are the longshots, also known as whisper stocks, and the whiz-bang stories. They probably reach your neighborhood about the same time they reach mine: the company that sells papaya juice derivative as a cure for slipped-disc pain (Smith Labs); jungle remedies in general; high-tech stuff; monoclonal antibodies extracted from cows (Bioresponse); various miracle additives; and energy breakthroughs that violate the laws of physics. Often the whisper companies are on the brink of solving the latest national problem: the oil shortage, drug addiction, AIDS. The solution is either (a) very imaginative, or (b) impressively complicated.
My favorite is KMS Industries, which, according to the 1980–82 annual reports, was engaged in “amorphous silicon photovoltaics,” in 1984 was emphasizing the “video multiplexer” and “optical pins,” by 1985 had settled on “material processing using chemically driven spherical implosions,” and by 1986 was hard at work on the “inertial confinement fusion program,” “laser-initiated shock compression,” and “visual immunodiagnostic assays.” The stock fell from $40 to $2½ during this period. Only an eight-for-one reverse split kept it from becoming a penny stock. Smith Labs fell from a high of $25 to $1.
I visited Bioresponse at its headquarters in San Francisco, after Bioresponse had first come to see me in Boston. There in an upper-floor office in a rather shabby section of San Francisco (this should be seen as a good sign) were the executives on one side of the hall, and the cows on the other. As I talked to the president and the accountant, technicians in lab coats were busily removing lymph from the animals. This was a low-cost alternative to removing lymph from mice, which was the usual procedure. Two cows could make all the insulin for the entire country, and one gram of cow lymph could support a million diagnostic tests.
Bioresponse was being closely followed by several brokerage firms, and Dean Witter, Montgomery Securities, Furman Selz, and J.C. Bradford had recommended it. I bought the stock in a secondary offering at $9¼ in February, 1983. It reached a high of $16, but now it’s a goner. Fortunately I sold at only a small loss.
Whisper stocks have a hypnotic effect, and usually the stories have emotional appeal. This is where the sizzle is so delectable that you forget to notice there’s no steak. If you or I regularly invested in these stocks, we both would need part-time jobs to offset the losses. They may go up before they come down, but as a long-term proposition I’ve lost money on every single one I’ve ever bought. Some examples:
—Worlds of Wonder; Pizza Time Theater (Chuck E. Cheese bought the farm); One Potato, Two (symbol SPUD); National Health Care ($14 to 50 cents); Sun World Airways ($8 to 50 cents); Alhambra Mines (too bad they never found a decent mine); MGF oil (a penny stock today); American Surgery Centers (do they need patients!); Asbetec Industries (now selling for ⅛); American Solar King (find it on the pink sheets of forgotten stocks); Televideo (fell off the bus); Priam (I should have stayed away from disk drives); Vector Graphics Microcomputers (I should have stayed away from microcomputers); GD Ritzys (fast food, but no McDonald’s); Integrated Circuits; Comdial Corp; and Bowmar.
What all these longshots had in common besides the fact that you lost money on them was that the great story had no substance. That’s the essence of a whisper stock.
The stockpicker is relieved of the burden of checking earnings and so forth because usually there are no earnings. Understanding the p/e ratio is no problem because there is no p/e ratio. But there’s no shortage of microscopes, Ph.D.’s, high hopes, and cash from the stock sale.
What I try to remind myself (and obviously I’m not always successful) is that if the prospects are so phenomenal, then this will be a fine investment next year and the year after that. Why not put off buying the stock until later, when the company has established a record? Wait for the earnings. You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later.
Often with the exciting longshots the pressure builds to buy at the initial public offering (IPO) or else you’re too late. This is rarely true, although there are some cases where the early buying surge brings fantastic profits in a single day. On October 4, 1980, Genentech came public at $35 and on the same afternoon traded as high as $89 before backing off to $71¼. Magellan was allocated a small number of shares (you can’t always get shares in hot public offerings). I did better with Apple Computer, which I sold on the first day for a 20 percent gain, because I was able to buy as many shares as I wanted. That was because a day before the offering, the Commonwealth of Massachusetts ruled that only sophisticated buyers could purchase Apple because the company was too speculative for the general public. I didn’t buy Apple again until after it collapsed and became a turnaround.
IPOs of brand-new enterprises are very risky because there’s so little to go on. Although I’ve bought some that have done well over time (Federal Express was my first and it’s gone up twenty-five-fold), I’d say three out of four have been long-term disappointments.
I’ve done better with IPOs of companies that have been spun out of other companies, or in related situations where the new entity actually has a track record. Toys “R” Us was one of those, and so was Agency Rent-A-Car and Safety-Kleen. These were established businesses already, and you could research them the same way you research Ford or Coca-Cola.
BEWARE THE MIDDLEMAN
The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation. SCI Systems (not to be confused with the funeral-home firm) is a well-managed company and a major supplier of computer parts to IBM, but you never know when IBM will decide that it can make its own parts, or that it can do without the parts, and then cancel the SCI contract. If the loss of one customer would be catastrophic to a supplier, I’d be wary of investing in the supplier. Disk-drive companies such as Tandon were alw
ays on the brink of disaster because they were too dependent on a few clients.
Short of cancellation, the big customer has incredible leverage in extracting price cuts and other concessions that will reduce the supplier’s profits. It’s rare that a great investment could result from such an arrangement.
BEWARE THE STOCK WITH THE EXCITING NAME
It’s too bad that Xerox didn’t have a name like David’s Dry Copies, because then more people would have been skeptical of it. As often as a dull name in a good company keeps early buyers away, a flashy name in a mediocre company attracts investors and gives them a false sense of security. As long as it has “advanced,” “leading,” “micro,” or something with an x in it, or it’s a mystifying acronym, people will fall in love with it. UAL changed its name to Allegis hoping to appeal to modern trendy thinkers. It’s a good thing that Crown, Cork, and Seal left its name alone. If they’d listened to the corporate-image consultants, they would have changed it to CroCorSea, which would have guaranteed a big institutional following from the start.
10
Earnings, Earnings, Earnings
Let’s say you noticed Sensormatic, the company that invented the clever tag and buzzer system for foiling shoplifters, and whose stock rose from $2 to $42 as the business expanded between 1979 and 1983. Your broker tells you it’s a small company and a fast grower. Or perhaps you’ve reviewed your portfolio and you’ve found two stalwarts and three cyclicals. What possible as-surance do you have that Sensormatic, or any of the stocks you own already, will go up in price? And if you’re buying, how much should you pay?